What is a Quality of Earnings (QoE) Report?
A Quality of Earnings (QoE) report is a sophisticated financial analysis used in M&A to evaluate the sustainability and accuracy of a company’s historical income. Unlike a standard audit, which verifies GAAP compliance, a QoE report focuses on Normalized EBITDA, identifying one-time anomalies, “add-backs,” and operational risks. It serves as the primary tool for justifying enterprise value and setting the “working capital peg” during a transaction.
EBITDA: An Essential Focus of QoE Analysis
An EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) analysis is a crucial component of a QoE report. It involves calculating the company’s EBITDA for a specific period, which is then analyzed to identify nonrecurring expenses, such as one-time charges or non-operating expenses, that may distort the company’s financial performance and valuation.
EBITDA analysis is vital in M&A transactions, as it helps potential buyers understand the underlying earnings of the target company. By isolating nonrecurring expenses, the EBITDA analysis provides a more accurate picture of the company’s operational earnings potential by focusing on core earnings.
This information is crucial for buyers to determine the target company’s value and negotiate favorable terms. A professional EBITDA analysis plays a critical role in a company’s QoE analysis and is often a key consideration in M&A due diligence.
Why Does a QoE Matter During an M&A Deal?
QoEs are essential for M&A deals and provide company owners and executives with critical information. Understanding the value of the bid at hand will help you make well-rounded, accurate decisions.
For instance, your firm is interested in acquiring a target that has recently reported an earnings increase. A QoE analysis can help determine whether that growth is sustainable and not simply due to a one-time event or accounting error.
If the analysis reveals concerns about the earnings quality, you can adjust your offer price or negotiate more favorable terms to account for the additional risk. Alternatively, if the analysis indicates a strong earnings quality, you can move forward with greater confidence, especially if you must increase the offer price to secure the deal.
A QoE performed by a professional accounting firm provides an objective and unbiased analysis, giving you an understanding of the target company’s financials. It also helps you avoid potential legal or financial liabilities that could be overlooked by poor due diligence.
A professional QoE report from an accounting firm can also help buyers negotiate better deal terms, such as purchase price adjustment, by providing a more accurate valuation of the target.
Why a QoE Trumps an Audit in M&A
Traditional audits look backward to ensure financial statements are not materially misstated. However, M&A buyers look forward. They need to know if the cash flow generated last year will persist under new ownership.
A Quality of Earnings report acts as a “truth-seeker” for enterprise value. While an audit verifies that a transaction occurred, the QoE analyzes whether that transaction was “high quality,” meaning it was generated by recurring operations rather than accounting maneuvers or a single lucky contract.
Key Entity Distinctions:
Audit: Focuses on historical accuracy and internal controls.
QoE: Focuses on future earning power and “bridge” adjustments from reported to adjusted EBITDA.
The Anatomy of a High-Impact QoE Report
A robust QoE analysis dissects a business into its core economic drivers. Expect these three pillars to dominate the report:
1. Revenue Quality and Customer Concentration
Analysts scrutinize the “stickiness” of your income. They look for “revenue leakage,” aggressive recognition policies, and customer concentration risks. If 40% of your revenue comes from one client, a QoE report will highlight this as a potential valuation discount, regardless of how profitable the company appears.
2. Expense Normalization and Management “Add-Backs.”
This is where value is often found or lost. “Normalizing” expenses involves stripping out costs that won’t exist post-sale.
Discretionary Spending: Private owners often run personal expenses (vehicles, travel, family salaries) through the business.
One-Time Events: Legal settlements, relocation costs, or specialized consulting fees are added back to reflect a “clean” operating profit.
3. The Net Working Capital (NWC) “Peg.”
The QoE determines the “normal” level of working capital required to run the business. This “peg” prevents sellers from stripping the company of cash or inventory just before closing. It ensures the buyer receives a functional engine, not just a shell.
Sell-Side vs. Buy-Side QoE
In the current market, the Sell-Side QoE has become a mandatory defense mechanism for private companies.
The Sell-Side Advantage: By commissioning your own report before hitting the market, you identify “skeletons in the closet” early. You can fix accounting errors or justify anomalies on your own terms. This prevents “re-trading,” where a buyer drops the price mid-diligence after discovering a flaw you did not disclose.
The Buy-Side Perspective: For buyers, the QoE is an insurance policy. It validates the seller’s claims and provides the data needed to secure acquisition financing from lenders who require a third-party validation of cash flow.
Red Flags and Deal Killers
A QoE report is designed to find “earnings erosion.” Common red flags that can tank a deal include:
Unrecorded Liabilities: Accrued vacation time or looming warranties that are not on the books.
Pro-Forma Fluff: “Future” savings that haven’t materialized yet but are baked into the asking price.
Inventory Obsolescence: On-book value for products that can no longer be sold at a margin.
Proof of Cash Gaps: Discrepancies between reported revenue and actual bank deposits.
Implementation Checklist: Preparing for Your QoE Analysis
To survive a QoE without a valuation haircut, follow these steps:
Clean the Ledger: Reconcile all bank accounts and credit cards to the penny for the last 24 months.
Document Add-Backs: Keep a meticulous “black book” of every personal or one-time expense.
Standardize Revenue: Ensure you recognize revenue when the service is performed, not just when the cash hits the bank.
Prepare a Management Presentation: Be ready to explain monthly fluctuations in gross margins.
Frequently Asked Questions (FAQ)
How long does a Quality of Earnings report take?
standard mid-market QoE typically takes 3 to 6 weeks, depending on the complexity of the company’s accounting systems and the speed of data delivery.
What is the typical cost for a private company?
Costs vary by firm size, but expect to invest between $20,000 and $75,000. While expensive, this often yields a 10x return by preventing price chips during the final stages of a deal.
Does a QoE replace a financial audit?
No. They serve different purposes. A QoE is a transactional tool, while an audit is a regulatory and compliance tool. Most sophisticated buyers will require a QoE even if audited financials exist.
Ensure Accurate Accounting Records
At Windes, we offer a range of M&A strategies, including financial and tax due diligence, working capital analysis, and quality of earnings analysis.
Our team of experienced professionals will tailor our services to fit your specific needs, no matter the size or complexity of your business. We can assist you in negotiating, structuring, and completing your M&A transaction with the most favorable outcome. From the initial letter of intent to post-close follow-up, we are here for you every step of the way to ensure accounting records are complete and accurate.
Contact our M&A Team today to learn how we can help with your M&A needs.
